Cash Loan Investors To LCDX: Drop Dead
October 6, 2008
If cash loan market participants got their hands on a DeLorean and a flux capacitor, some might use it to travel back to May 22, 2007 and stop the launch of the Markit LCDX index.
“The LCDX has become no different than other highly-leveraged, unregulated, opaque over-the-counter credit default swaps,” a Boston-based investor said. “On the surface today, it seems it was a big, bad idea. The counterparty risk alone made it a questionable practice, as we are now discovering very quickly. … I’m sure there is a good side to the CDS story; I just don’t know what it is.”
Cash loan investors’ objection to the LCDX stems from the access to the market it has provided to synthetic loan players like hedge funds, who cash loan investors say interfere with pricing. It has gotten to where no one can tell if cash drives the index or vice versa, sources say.
“In theory, the index should be merely a derivative of where underlying cash instruments are trading. But what you find on crazy days, which have been the norm for the past 14 months, is that some hedge fund puts in a $1 billion trade on the LCDX (and you know they want to sell it) and that moves the cash. The value of our holdings is being manipulated by someone trading synthetically,” a CLO manager said.
The good news for cash loan investors is that this year’s wild ride on the secondary has already knocked some hedge funds off the bull, which could spell the beginning of the end for the index, some market players say.
“Going forward, there will be a lot fewer hedge fund players because a lot of them have blown up. So the need for [the LCDX] is going to decline significantly,” the CLO manager said. “If [the LCDX] can’t generate the trading volumes, then it becomes an albatross around the market. So the question of whether or not the LCDX should’ve been introduced in the first place becomes less relevant in six months, when all the hedge fund guys are gone.”
Prices on the index last week continued to slide, mirroring what was happening in the stock market. At the end of the day Wednesday, the average price on the LCDX stood at 92.48. Prices on the index hit a low back in February of 91.1. During the first half of September, approximately 35% of secondary loan bids were between 70 and 90 cents on the dollar, and roughly 10% were lower than 70, according to the Loan Syndications and Trading Association and Reuters LPC.
In May of 2007, more than 70% of all bids were around par. Currently, 2008 vintage deals are faring better than 2007 deals, with roughly 45% of ’08 vintage deals trading above 98, while 40% of first half 2007 deals, and approximately 30% of second half 2007 deals, are trading in the low 90s.
Tom Price, a managing director and global head of credit for Markit, says the Markit LCDX provides investors a tool to take a long or short macro view of the syndicated loan market. “After its launch, one of the largest investors in the loan asset class compared the LCDX to the Bar scene in Star Wars,” he said. “For some investors in the Loan CDS market, the cash loan market may appear very foreign as well.
Loan CDS and cash loans are linked, but they are also distinct markets. They have different investor bases. One is a derivative and one is not. One is funded and one is not. Participants in the loan CDS market want to make it more liquid, not less. The loan CDS market is actively working on a revision of [contracts between buyers and sellers] to enable more liquidity.”
Cash loan investors who say the index is destabilizing the market may have their own incentives to make those claims. Some proponents of the LCDX say cash loan investors blame the LCDX rather than admitting they have a lack of bids for what they own. Furthermore, cash loan investors may not understand how the index works. While much of the heat is on the LCDX, bond indices also distort the credit markets, sources say.
“Even when everyone lines up to sell, you get this overshooting,” said Bill Larkin, a portfolio manager at Cabot Money Management. “I’m looking at short-term investment-grade corporate bonds that have around 4% [return] swings in one day, which is usually the return that bond gets in one year. So there is this extreme difference in valuations.” But regardless of how they see the LCDX, most think it’s a useful hedging tool for a lot of trading desks.
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